Definition
A loss from rental property or other passive activities that is limited in deduction based on income level; losses above the $25,000 threshold are suspended and can be deducted when the property is eventually sold.
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Real estate investors often have losses in early years due to depreciation, mortgage interest, and expenses exceeding rental income. Rental losses are passive by law, however much work you put in, unless you qualify as a real estate professional (below). Passive losses are limited to $25,000 annually if Modified Adjusted Gross Income (MAGI) is under $100,000, phasing out completely over $150,000 MAGI. Losses above limits are suspended—not lost, but deferred. When you sell the property, suspended losses can be used against the sale proceeds. Real estate professionals (who spend more than half their working time, and over 750 hours a year, in real estate businesses, and who materially participate in their rentals) can bypass passive activity limitations and deduct all losses. Understanding passive activity limits is crucial for investment strategy—properties should be profitable (not loss-generating) unless you qualify as an active professional or have income low enough for full deductions.
Pro Tip
If you own rental properties and take significant depreciation losses, ensure you understand passive activity limitations. Losses above limits are deferred, not lost, but deferral reduces current-year tax benefits.
Example
A rental property generates $20,000 loss annually from depreciation and expenses exceeding rent. Owner's MAGI is $120,000. Up to $15,000 of the loss is deductible (the $25,000 allowance less half of the $20,000 of MAGI over $100,000); the other $5,000 is suspended and carried forward.